Ask Me Anything — The Demonetization Edition

Money is important. The real economy cannot function without a stable and predictable currency. Money serves as a numéraire, which the wiki defines as “a basic standard by which value is computed . . . the numéraire is one of the functions of money, to serve as a unit of account: to provide a common benchmark relative to which the worth of various goods and services are measured.”

These days, nearly all money is fiat money issued by the central bank of an economy which is controlled (indirectly perhaps) by the government. The quantity, and therefore the “price” of money (which is the interest rate), is controlled by the central bank.

Money is also a medium of exchange. Without money, all exchanges would be reduced to barter. Barter suffers from the problem of a “double coincidence of want” which basically means that you have to find someone who has precisely what you want and who also wants what you have in exchange — an almost impossible task in a world where there are literally billions of people and millions of distinct goods and services.

Finally, money is also a store of value. People borrow and lend in money terms.

Of the three functions of money–unit of account, store value, and medium of exchange–the fact that it facilitates exchange is the most critical. Disruptions in the money supply is akin to the disruption in the air supply for a human being. Remember the rule of three: you can survive for three weeks without food, three days without water, and three minutes without air. The economy can survive a disruption in the money supply for a few weeks but not without suffering some damage.

Deliberately inducing a critical shortage of money should not be a matter of whim. The costs are immense and such a move can only be justified in the fact of clear and present danger. To use a medical analogy, it is like chemo or radiation therapy: the side-effects are nearly as damaging as the targeted malignancy.

On Nov 14th, just a few days after Nov 8th (what I call India’s 8/11), I wrote a blog post that was republished on The Quint. Yesterday I wrote another piece on the matter. Here it is, for the record. (Link to The Quint article. I should clarify that the title of the piece is not mine.)

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Note Ban: A Blunt Instrument That May Spark Greater Economic Evils

In his 1848 essay ‘What is Seen and What is not Seen’, celebrated French economist Frédéric Bastiat enunciated an important truth that any action in the economic sphere produces not just one effect but a series of effects. Some of these effects, he wrote, are intended and foreseen, others are unintended, unseen and unforeseen. Furthermore, only some of the consequences are immediate while others unravel over time.

He went on to observe that “it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

The best laid schemes of mice and men often go awry, as the poet lamented, because we are not given unbounded rationality and foresight. Therefore, it is best to exercise extreme caution when making bold moves in our personal lives.

That caution has to be multiplied a thousand-fold when an action is sure to affect untold millions of people, as when governments make potentially game-altering policies.

The Indian government’s 8 November decision to demonetize Rs 500 and Rs 1,000 notes is one such bold policy. The motivation for that action was, no doubt, benevolent. The expressed goals changed with time, from the high-minded elimination of “black money” and counterfeit currency, to the rather questionable goal of moving India towards a “cashless” digital economy.

Removing an estimated over 80 percent of cash in hand has to have dire consequences for any economy, especially one in which a vast majority of transactions involve cash.

We must remember that the act of exchange and trade, buying and selling, lies at the heart of both production and consumption, and that money is what keeps the whole system functioning. Without some form of money, most non-barter exchanges will come to a halt or at least slow down and so would the economy.

It is like when you forget your wallet at home and cannot buy what you need from the market, and it causes some inconvenience to you. Your money is still there, but you don’t have access to it. But if a few hundred million people suddenly don’t have access to money – even temporarily – the impact can not but be staggeringly negative.

Demonetisation of that scale is a blunt instrument for attempting to eliminate black money. Black money itself is only a symptom of a structural problem in the economy. Without a structural change in the system, even if the stock of black money is entirely eliminated, the flow will resume and soon enough the stock will recover.

What’s worse is the likelihood that much of the existing stock of black money will not be eliminated because people are endlessly inventive and if they have had the smarts to accumulate black money, they can be trusted to figure out ways and means to launder much of their stockpile.

The benefits of the demonetization have to be considered in relation to its costs. Only a small segment of the population are people who have black money because crooked politicians, judges, and bureaucrats, and business people with undeclared incomes are a minority in any population. Most people in India have neither the capability nor the opportunity to generate black money. Making the innocent majority pay for the sins of the culpable minority is morally wrong and economically inefficient.

The benefits are dubious at best and the costs in terms of loss of income and economic output are massive. If the government is serious about removing black money, it needs to address the root of the problem: needless heavy-handed political and bureaucratic control of the economy. That control has been in place since colonial times and the system created the incentives for people to cheat. Only by changing those incentives will people respond by not cheating. Symbolic actions, however sincerely felt and however dramatically executed, cannot begin to address deep rooted problems.

The sad fact remains that those who have the power to make those needed structural changes have the least incentive to make them since the present system is what gives them the power.

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So there we are. This is our “Ask me anything” for December. What’s on your mind?

If I were the PM, I would work sincerely to reduce the size of the government, which in concrete terms means to understand precisely what the role of a government in a free society is, and then restricting the government to only those functions. I have briefly outlined what that function ought to be in the draft constitution that I have on this site. The government should not be in business, should not be in the business of income redistribution, should not be in the business of interfering in the freedom of the citizens to live their lives as they see fit. In short, the only role of the government is to ensure (guarantee, guard) that citizens are free from coercion from other citizens and the government.

Yes, I did believe that Modi will change the rules of the game. I was wrong in my belief. As it has become evident now, he considers all problems that people face arises from their incompetency, and the remedy is for a nanny state to dictate to the finest detail what they should and must do.

It is my conjecture that the Maino gang which was in power for so many years has not entirely lost its grip on the government machinery. Who these Maino moles are is not hard to figure out. Should they be named? That would be foolhardy. I am not being paranoid, just recognizing reality it is dangerous to oppose the powerful in a not-free society like India.

Considering the number of people who are in possession of black money in the form of newly minted notes (as evident by the media coverage of IT raids uncovering crores of black money everyday), the leaky faucet should have been fixed instead of wiping the wet floors. Any reason why this was not the case and the symptom was tackled instead of the root cause ?

The one leaky faucet that China fixed, which has been foundational in taking it where it is today, is procreation. In India, before you fix any problem for five people, be it school blackboards, dengue, malaria, or black money, 10 are born who will cancel and exceed the deluge you have just painfully mopped up.

We already have big issues with Govt confiscating cash and property(next in line) and inconveniencing 99% of people in the name of unearthing black money. The last thing we need is Netas telling us “how/when/how many” to have kids.

Hopefully people will not jump the gun and vote for Rahul in the next election.

Fixing the leaky faucet is better than constantly wiping the floor. Good analogy.

Tackling the symptom is politically more rewarding as it demonstrates to the voters that the government is serious in curbing “black money.” That illusion works when the citizens are uninformed about the cause of the problems which ultimately is an intrusive, colonial government. Doing the right thing — granting people freedom — does not appeal to those who wish to control and dictate to others.

If smashing a Madhya-Pradesh-sized hammer into an appendicitis patient is “surgery”, then this is a “surgical strike”. Otherwise, please use the more accurate description: “carpet bombing”. Indians just give away their ignorance (not of English but ignorance in general) by not using the correct names for things.

I am surprised no economist has pulled out the blood-as-money analogy:
As blood circulates through the body, it gets increasingly contaminated with toxins and waste products. Then it passes through the major and critical organs, the liver and the kidneys, that clean it up. Blood is circulated through these organs 24×7, because contamination also happens 24×7. When kidneys begin to fail, intermittent dialysis is performed for reasons of practicality; but dialysis is a far cry from the real continuous thing. Both liver and kidney failure have poor prognosis, because there is no substitute for the continuous circulation and filtering. A “surgeon” may instead choose to puncture a bunch of arteries, flush all blood out of the patient, clean it in a vat somewhere, inject it over a month through one or two canula back into the blood vessels, and give violent shocks to the heart with a hope to restart the pump and revive the patient. Such a “surgical strike” can perhaps raise Frankenstein’s monster, but not a cured patient. Realistically, the “surgeon” ends up with a cadaver. In the current situation, lots of cadavers. You would call such a “surgeon” a “quack”, or rather a “vampire”.

Events are on a roll now, there’s no turning back any more. The government should not back down while there is a single Indian still left alive. At least crematoriums are accepting old cash. After that, there’s always the old cash as fuel.

I agree that we should be careful about vocabulary and use the proper terms. But the conclusion that the “government should not back down while there is a single Indian still left alive” is a counsel of despair. We the people are ultimately responsible for the society that we live in. We can change the way things work provided we care enough. Passively accepting the insanity of the powers that be is not a good strategy.

I’ll have questions later. .but for now doesn’t it just give you a sinking feeling that we thought this guy is going to reform and all and he instead did this and we still don’t have any one to replace him. A society of 1.2B people and we essentially have no major political party heck as of this moment we have no major politician speaking any sense.

(Your comment got categorized as spam by akismet. You may wish to see if your reputation has been compromised for some reason.)

Modi was supposed to do reforms. But he did not and is very unlikely to. I think that the reason is that he does not understand what reforms are needed. I cannot fault him for not understanding. After all, understanding it requires years of study (for the average human) and is generally counter-intuitive. Only a select few are given the insights that allow them to know what needs to be done without too much effort.

Modi is probably sincere and certainly overworked. Sincerity itself does not guarantee anything. I could sincerely believe that administering cyanide for a stomach upset is the best medicine. Workaholics do get more stuff done but quantity does not compensate for quality ever.

“We have no major politician speaking any sense,” you write. Does that surprise you? It doesn’t surprise me. Here’s why. An analogy. It does not surprise me that “no major sumo wrestler has ever been known to be a marathon runner.” Major politicians have to specialize in speaking what is likely to get them votes. Speaking sense will not endear them to voters. Why? Because the voters want stuff for free. Any politician figures out what to do to win: promise stuff that they probably know they cannot deliver. That imposes costs on the economy and the people suffer. The people don’t understand that and so the politicians keep doing what suits them.

I’ve been following yours and sabhlok’s blog for a long time now. You have always stated that a society needs central banking to manage the money supply.

But now with the internet it’s possible to bypass that and truly decentralize money as bitcoin does. And with new tech advances like the signal protocol it would be impossible to censor these without blocking the whole internet.

Sabhlok has also written about the “impossibility of central banking” and ending govt monopoly on money.

What are your thoughts on this?

PS: Here’s some further good reading for everyone on this idiotic demonetization move. My only incentive in sharing these links is the spread of right ideas.

You had endorsed Modi & party during the 2013 elections. Would you continue it and support them for 2018 also? I feel this Tughlaq is worse than congress Ghazni’s we had. If Modi can do anything he likes without any constitutional restraints, capital is fleeing out of India very soon and we will be back to Indira’s India. After confiscating the cash, his next hare brained scheme (coming soon) is to confiscate property. Please be vocal and oppose these policies with the same fervor you showed towards opposing congress and supporting Modi. Otherwise you will lose credibility at least in my eyes.

I read the draft constitution that you had made. I expressly liked the following sections – Article 7, Article 13, Article 6.

I have a few questions about some of the articles, I was wondering if you could expand on them.

In article 7 section 6 – “Missionary activities, including charity, of all foreign
and domestic agencies shall be prohibited.” Will this not violate the freedom of religion part of the constitution. Isn’t practicing and spreading a religion part of freedom of religion.

Article 6 Section 5 – “The national and state governments shall ensure that
India is 100 percent literate within five years of
adoption of this constitution.” Is this even feasible? How are we supposed to accomplish something in 5 years that we have not been able to do in 70 years. What if the govt. fails to meet the deadline? How is the govt. supposed to accomplish this task?